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Some Concern

Apparently there’s some concern
Investors will soon start to spurn
New Treasury debt
Which could be a threat
To equity prices in turn

It seems that we could be heading back to the ‘good news is bad’ situation that existed several years ago. Yesterday’s Retail Sales data printed pretty much as expected at 0.3% although there were revisions higher to the previous data making the report, on the whole, seem quite robust. The immediate market reaction was a sharp sell-off in Treasury bonds with the 10-year yield touching as high as 3.09% before settling up 8bps at 3.077% at the end of the day. This is the highest level since March 2011 and has reignited the conversation about just how high yields will go. This morning’s punditry has seen an increase in the number of stories talking about a move to 3.25% or 3.50% before long and what might be the potential consequences of such a move. This cannot be that surprising as it has become increasingly clear that inflationary pressures in the US continue to point higher. Another tidbit is the fact that the Fed Funds futures market is now pricing in a 55% chance of a fourth Fed hike this year, its highest level to date.

The market impact beyond Treasuries was quite clear as the dollar surged to new highs for the move while equity prices suffered, albeit less than they might have. Interest rate spreads between the US and the rest of the G10 continue to widen in the US’ favor and as long as this continues you can expect to see the dollar supported. The historic link between rates and the dollar is firmly back in place at this stage, and I see no reason for it to break in the near future. As such, with US rates looking very much like they have further to rise, I’m confident the dollar will come along for the ride.

But that is not the only thing helping the dollar this morning, there are two other stories that have helped feed the evolving narrative of US growth leading the pack. First, Japanese GDP in Q1 shrank -0.2%, its first decline since Q4 2015, and a surprise to most forecasters. While the discussion is that this is a temporary phenomenon having to do with bad weather and uncertainty over the global trade situation, the reality is that while the US continues to see data at or better than expectations, the rest of the world is lagging. Interestingly, while the yen did fall during yesterday’s session, it has actually rebounded slightly, just 0.15%, this morning. The other story that is getting some press, although not as much as I expect it will eventually, is from Italy, where the League and Five-Star parties continue their negotiations to form an anti-establishment government, and have discussed the idea of writing off €250 billion of Italian government bonds!Given that Italy’s debt/GDP ratio is an unhealthy 132%, it can be no surprise that a completely new and reactionary government doesn’t want to be held back by their predecessors’ profligacy (after all, they have their own profligacy to consider!) However, if this actually moves into the Italian government platform, it is going to be devastating to government bond markets throughout the world, and I assure you that the euro will not fare well either. In fact, this morning the euro is down a further 0.4%, trading below 1.18 for the first time since December 2017. The trend here remains very clear and I continue to believe the euro has further to fall.

I have written before about the idea of a debt jubilee, where central banks tear up maturing bonds and leave the cash in the system thus reducing government debt outstanding and expanding the money supply. This would be highly inflationary. When looking around the world at record high debt levels, it is something that has to be considered possible. While I have always believed that Japan with its 230% debt/GDP ratio would be the first country to consider it, Italy had to be a candidate. And since it is evident that the new government is willing to consider radical changes in the way things are done there, I guess it shouldn’t be a big surprise. But it would have a monumental impact on financial markets if they were to do this, with risk being shunned everywhere and haven assets exploding higher. I’m not saying this is going to happen, just that the probability has clearly turned non-zero. Watch this space!

With all that in mind, the dollar continues to power ahead vs. both G10 and EMG currencies although most of the individual stories are less interesting. The one outlier this morning is ARS, which actually rallied nearly 4% yesterday after the government was able to roll over $26 billion equivalent of local currency debt, albeit paying between 38% and 40% to do so. While the market did take the news well, I don’t have to remind you that paying 40% interest is not really sustainable. If the IMF deal isn’t closed soon, I fear things there will really get out of hand. But that was the only bright spot on the day. We continue to see TRY (-1.8%), BRL (-0.9%), IDR (-0.5%) and KRW (-0.9%) lead the way lower across the board. And here, too, there is no reason to expect that the situation will change. In fact, the ongoing issue with the emerging market currencies is that higher US interest rates are beginning to compete effectively with investment opportunities in those countries. As such, investors are looking at 3.0% in the 10-year Treasury, a riskless yield, and it is starting to compare favorably to everything else available. Complicating the cycle for EMG economies is that they have been on a USD borrowing binge for the past eight years and it is becoming increasingly more expensive to service and repay that debt, weakening those economies. Here too, I think the dollar has further room to run.

Looking ahead to this morning’s data we see Housing Starts (exp 1.325M) and Building Permits (1.35M) along with IP (0.6%) and Capacity Utilization (78.4%). What we have learned from the inflation data is that the housing market remains robust. And given the tax changes, there is a clear expectation for gains in Capex, which should help the other data this morning. In other words, it is difficult to look at the data and come away with a rationale for either Treasuries or the dollar to reverse course. In fact, my take is that we could see the dollar continue to rally through the end of the week, whereupon traders are more likely to start taking profits before they go home for the weekend.